Stress Testing Your Dividend Portfolio For Safety

by Dividend Growth Investor | August 30, 2012 7:00 am

As I explained in my article on my dividend retirement plan[1], I invest in blue chip dividend stocks which can afford increase dividends for decades. Once the dividend income from my portfolio exceeds my expenses[2] I would consider myself financially independent. However, I realize that there are many risks I need to minimize, in order to be able to enjoy the continued stream of rising dividend payments.

The types of stocks I purchase tend to be companies with wide moats[3] or strong competitive advantages which have pricing power and customer loyalty. These companies have been able to expand sales and profits and managed to pay a higher dividend in the process every year. These companies are attractively priced at the time of purchase and have sustainable dividend payments.

The fact that these companies have paid rising distributions for years if not decades and the fact that they offer above average yields is just icing on the cake. The types of companies I invest in include Johnson & Johnson (NYSE:JNJ[4]), Wal Mart (NYSE:WMT[5]), Chevron (NYSE:CVX[6]), Enterprise Product Partners (NYSE:EPD[7]). There are several risks however, which would be dividend retirees need to consider.

One risk which is seldom addressed by most financial advisors is broker failure. Most clients at SIPC insured brokers will be able to get back up to $500,000 in assets or $250,000 in cash in case their broker fails. If this broker had no internal controls to keep customer funds segregated, investors which hold more than the SIPC insured level risk receiving pennies on the dollar in assets that were rightfully theirs.

As a dividend investor, I would hate to lose even a portion of my income stream just because my broker fails. As a result, my dividend growth plan made certain that I spread my assets across several brokerages and that I do not commit more than $100,000 per brokerage. I plan on putting a smaller amount in comparison to the SIPC limit because I expect my stocks to deliver solid capital appreciation over the next few decades. In addition, it is much easier to spread my funds across brokerages $100,000 at a time, than $500,000 at a time.

Another risk which I continuously stress is diversification[8] of my individual portfolio. I hold more than 40 individual stock positions in my dividend stock portfolio. I hold a full-time job, and still manage to find time[9] for my portfolio and have a life as well. If two stocks that I own eliminated their distributions in an equally weighted 40 stock portfolio, I would suffer a 5%decrease in portfolio distributions.

Chances are that if my other companies keep raising distributions at the 6% expected rate, my dividend income would break even for the year. If you have a 10 stock portfolio, and two of the stocks you owned eliminated distributions, your income would be down by 20%.

I witnessed the collapse of dividend income for many dividend paying financial darlings such as Citigroup (NYSE:C [10]), Bank of America (NYSE:BAC[11]), US Bancorp (NYSE:USB[12]) and Wells Fargo (NYSE:WFC[13]). This experience has also taught me to not overcommit to a certain sector.

If a dividend investor has equally weighted exposure to 8 sectors, and the companies in one of these sectors experience severe decreases in distributions, the total portfolio income would not be decimated.

Compare this to a typical portfolio from before the financial crisis, which could have been heavily weighted towards financials, and you would understand my conservatism. Another example lies with the investors in Canadian Royalty Trusts[14] were blinded by the high yields in the sector. Fast forward several years, and most of these investors have suffered massive decreases in distributions.

A third risk that could derail anyone’s retirement plans includes deflation. This economic condition occurs when the general price level declines due to lack of demand and oversupply. The US experienced massive deflation during the Great Depression of 1929 – 1933, when the Consumer Price Index fell by 27%. Stock prices fell by 91% in July 1932 from their highs reached in September 1929. Dividend payments on Dow Jones Industrials Index fell by 73% during the same period as well.

The only component that would have saved investors’ portfolios were U.S. Treasuries, which kept paying their coupons. The past 20 years in Japan have also showed investors that allocation to government bonds is the best investment during deflation.

I have long been ridiculed for my ideas that retired investors should have at least a 25% exposure[15] to fixed income – US Treasuries or Agency Bonds being the safest fixed income. The truth is that investors who plan on relying on their portfolios for income in retirement should have exposure to assets which have different economics. Stocks and Rental Real Estate should do well during moderate inflation and during periods of economic growths. They are also going to maintain some purchasing power during high inflation.

Bonds on the other hand would maintain their income stream during severe recessions, depressions and deflations. While 10 year US Treasury Bonds yield less than 2% today, there were several times over the past two years when they yielded close to 4%. Currently, 30 year Treasury Bonds yields 2.70%, but they used to yield close to 5% on several occasions over the past few years.

The key to accumulating fixed income is purchasing a set amount every month or so. I plan on using the dividends from my stock portfolio for 5 years before my retirement date to purchase fixed income. While current yields look low, they could still go lower or remain low for extended periods of time. The yields on long-term Japanese Government bonds have been declining for years, as have the yields on US Bonds.

Two years ago, Roger Nusbaum ridiculed my article[16] on Four Percent Rule[17] for Dividend Investors in Retirement by claiming that bond yields were low and could only go up. Little did he understand that bonds play in important role that diversifies a retiree’s portfolio and passive income stream against unforeseen events. To Japanese savers in the late 1990s, a 10 year bond yielding 2% might not have sounded like much. Fast forward to 2011, and it is hard to even obtain that yield in a 10 year JGB.

Last, one of the final rules I have is to immediately sell[18] a stock after it cuts or eliminated dividends. This would have had investors sell Citigroup in early 2008, Bank of America and Lehman Brothers (PINK:LEHMQ[19]) before the bankruptcy. This rule ensures that I get out of a position with negative income characteristics that could wipe out a portion of my capital. It also ensures that I sell a company which I like, even if the fundamentals have deteriorated over the years.

Eastman Kodak (PINK:EKDKQ[20]) paid dividends for many decades, but when the company cut distributions in 2002 at the time that the stock traded at $30 per share. This was 9 years before the company filed for Chapter 11.